This week, The Week ran an opinion piece by John Aziz which argues that America (and all other nations for that matter) should keep borrowing until investors no longer want to lend to them. To this end, it is argued, the US should scrap its debt ceiling because the only debt ceiling it needs is the one imposed by the market. When the market doesn’t want to lend to you anymore, it will stop lending to you at the margin and your bond yields will rise to such an extent that you can no longer afford to borrow any more money. You will reach your ‘natural’, market-determined debt ceiling.
The story goes like this: American bond yields are incredibly low, which means there is no shortage of people willing to lend to Uncle Sam. So Uncle Sam should take advantage of these fantastically easy loans and leverage up.
I’ll reprint the most egregious paragraph:
The U.S. government is legally bound to pay its debts, and as the issuer of currency it has the means to do so. This means that U.S. government debt is considered by the market to be a very safe asset. And, as Frances Coppola argues, that means that it is a critically important part of the global financial system, because it is used around the world as collateral for lending and as a store of purchasing power. Right now interest rates are very low by historical standards, even after adjusting for inflation. This means that the government is not producing sufficient debt to satisfy the market demand. The main reason for that is the debt ceiling.
Firstly, the US government is “legally bound” to repay its debts in much the same way it was “legally bound” to redeem gold at $35/oz. We know how that turned out. Sovereigns have a long-established tradition of flouting the “law.” Moreover, the fact that America can issue its own currency is categorically no different from almost every other government default in history. When currency issuing governments can’t pay their debts they either print money and destroy the currency, or they default outright.
As to Frances Coppola’s assertion that the dollar is the world’s safe haven reserve and collateral asset, that is only a positive historical statement. But it doesn’t account for how this is changing at the margin. The question is not whether the dollar is an important part of the global financial system, but whether it is more or less important than 1, 5, 10 or 20 years ago? I’m not going to answer that question in detail here but for making two points: 1) The Week article makes no mention of the crucial importance of the marginal global status of the reserve dollar, and 2) the evidence is mounting up that it’s status is waning fast, from the introduction of rival reserve currency, the euro, to other major political and economic blocs actively seeking reserve diversification, to foreign central banks actively accumulating gold, to the obvious goal of China to usurp global reserve currency status.
But, Aziz argues, the evidence is against me, because just look how low US bond yields are – clearly there’s ample willing holders of US dollar reserve debt securities!
Except that 80% of all new US debt issuance is being lapped up by the government’s money printing bureau, the Fed. This is the opposite of the United States government “not producing sufficient debt to satisfy the market demand.” On the contrary, Uncle Sam has produced $6 trillion of debt since the financial crisis, of which the Federal Reserve has purchased about a third with money conjured out of thin air, making it the largest single ’lender’ to the US government. In addition, the Fed has contrived the Fed Funds Rate to zero % by effectively eliminating any money market shortages for the banks, which is a fancy way of saying it’s printed a lot of money (outside of QE programmes) for the banks. Through contrived zero-bound short term rates and vast money printing to buy up government debt, the Fed has effectively bailed out the insolvent banks and the United States government by containing interest rates at exceptionally low levels.
US bond yields are currently no more a reflection of the market’s demand for US debt than an ordinary price control is a reflection the real demand and supply conditions for a particular product. In fact, contra the view expressed by John Aziz, low rates bought about by contrived zero-bound policy rates and trillions of dollars in QE falsely encourage more federal government borrowing while at the same time pushing savers and investors out of US bond markets and into riskier assets like corporate bonds, equities, exotic derivatives, emerging markets, and so on.
What QE has done is pumped money into the financial system but created no more willingness among private investors to lend to Uncle Sam. Now, it would be countered that if the Fed is just printing up money to monetise US debt, why isn’t the world dumping these debased dollars. This is proof, according to this line of thinking, that whether the Fed or investors are buying the debt, the fact that the dollar is not being sold off confirms that everyone’s ok with this set-up.
But the dollar is selling off. It’s down over 20% against the S&P 500 this year, 13% against houses. Even the supposedly ghastly euro is up against the dollar, as is no-growth Britain’s pound. It’s true the dollar has firmed against gold, but to say the paper gold market isn’t a good reflection of the underlying insatiable demand for the yellow metal is a major understatement. Physical gold premia have been rising and it’s harder than ever to get hold of the real stuff as investors continue one of the biggest private global physical gold hoards in history.
Moreover, to assert US inflation is only 1% is laughable. I’m not sure which god of economics decided CPI was the only proper representation of the loss of money’s purchasing power (i.e. price inflation), but whoever it was, was either delusional or trying to pull some kind of a coup. Yes, it’s true that CPI inflation is soft. But more broadly there is inflation in all kinds of assets, not only within America, but abroad too in emerging market assets. And not just a little inflation either.
There is nothing about low bond yields in today’s world of hyper money market distortions, asset inflation, and soaring government debts that suggest investors are unsatisfied by the amount of debt governments are “producing.” Instead, I see the very opposite. Through a myriad of interventions and with the generous use of the printing press, governments are propping up a debt structure by pretending there is more savings available to them than is truly the case. Private investors on the other hand consider low real yielding government bonds a fool’s investment. Most funds I speak to care nothing for bonds offering them negative real yield, when REAL, broad inflation is taken into account. After all, what use is it to an investor if his bond portfolio income keeps him ahead of CPI but sees him falling behind stock prices, house prices, corporate bond prices, college prices for his children or asset prices around the world?
Greece once thought that the market was giving it the green light to “produce” more debt. Low borrowing rates for Greece were not a sign of fiscal health, however, but really just layer upon layer of false and contrived signals arising from easy ECB money, Greece hiding behind Germany’s credit status, and a massive credit boom fueled by contrived cheap and easy money across the globe. It turned out though, that a legislative debt ceiling (one that was actually adhered to) would have been a far better idea than letting contrived interest rates be its debt ceiling. Investors were happy to absorb Greece’s debt until suddenly they weren’t.
This is the nature of sovereign debt accumulation driven by easy money and credit bubbles. It’s all going swimmingly until it’s not. And there is little reason to think this time the US is different. Except that America might be worse. The market has effectively already voted down US Treasuries – the very reason why the Fed has been forced to step into the gap. The very fact of QE proves Washington is producing too much debt. Theory and history are clear about the reasons and consequences of large-scale and persistent debt monetisation.
Finally, Aziz asserts that the main reason for the US not “producing” enough debt, is the debt ceiling. This is perfectly wrong. The debt ceiling has never provided a meaningful barrier to America’s borrowing ambitions, hence the dozens of upward adjustments to the ceiling whenever it threatens to crimp the whims of Washington’s profligate classes. America’s new borrowing is falling because all the money it has recently printed washed into the economic system and found it’s way back into tax revenues. Corporate profits are soaring to all time highs on dirt cheap trade financing. Companies are rolling their short term debts super-cheaply thanks to Bernanke’s money machine and issuing long too into a bubbly IPO and corporate bond market. The last time corporate profits surged like they’re doing now was during the credit and housing bubble that preceded the unraveling and inevitable bust in 2008/09.
So effectively Uncle Sam printed up his own tax windfall, a plainly unsustainable way to right your fiscal ship. The debt ceiling has had precious little to do with it. Not only has it been raised every time after some political points-scoring on Capitol Hill, but when it has acted as a constraint, the US Treasury has worked around it using “extraordinary measures.”
Moreover, US debt is neither crimped nor the US Treasury Department austere. Instead, the national debt is soaring, up by $60,000 for every US family since Obama took office and rising. Add to this the fact that the US Treasury’s bond issuance schedule is actually set to RISE in 2014 due to huge amounts of debt maturing and needing to be rolled over next year, and the economic significance of the debt ceiling fades even further.
The brilliance of the debt ceiling however, is that it keeps reminding everyone that there is a growing national debt that never seems to shrink. That is a tremendous service to American citizens who live in the dark regarding the borrowing machinations of the their political overlords. Yes, politicians keep raising the debt ceiling, but nowadays they have to twist themselves into ever greater pretzels explaining why to their increasingly sceptical and cynical constituents. Most people don’t understand bond yields and QE and Keynesian pump-a-thons too well, but they sure understand a nominal debt ceiling.
Aziz and others who adhere to the don’t-stop-til-you-get-enough theory of sovereign borrowing, and by extension argue for a scrapping of the debt ceiling, couldn’t be more misguided. In free markets with minimal, natural levels of money market distortion, interest rates can be a useful guide of how much real savings is being made available to borrowers. When borrowers want to borrow more, real interest rates will rise, and at some point this crimps the marginal demand for borrowing, acting as a natural ‘debt ceiling’. But when markets are heavily distorted by central bank money printing and contrived zero-bound rates, interest rates utterly cease to serve this purpose for prolonged periods of time. Greece provides a recent real world case study of this very phenomenon in action. In these cases we are more likely to see low rates sustained during the increase in government borrowing, only for them to quickly reset higher and plunge a country into a debt crisis which may force default or extreme money printing, which risks a hyperinflationary crisis, the worst outcome of all.
In reality, few investors want to park their funds in loss-making assets like US Treasuries. Some are forced to due to long-standing mandates (funds) or habit/convention (foreign central banks), but on the whole investors would far rather be in something that protects against all the Fed’s debasement, like stocks or houses or cars or gold. This by the way is Bernanke’s hope – that while the Fed soaks up all the debt, you’re piling into risk. China agrees, stating recently that it sees no more utility accumulating any more dollar debt assets.
Of course, debt monetisation has a proven track record of ending badly. It is after all, when all’s said and done, the implicit admission that no one but your monopoly money printer is willing to lend to you. The realisation that this is unsustainable can take a while to sink in, but when it does, all it takes is an inevitable fat-tail event or crescendo of panic to topple the house of cards.
Let’s see how much the US government would be able to borrow if the Fed wasn’t contriving rates down to zero by printing money for the banks and printing $85 billion every month in QE, and if commercial banks didn’t also have a licence to print credit money out of thin air. Then we’d see what a natural debt ceiling really looks like.
Russell Lamberti is Head Strategist at ETM Analytics, in charge of global and South African macroeconomic, financial market, and policy strategy.